Rainy Day Funds Explained: How Much Money Should States Have in the Bank?

Office of Governor Rick Perry
Texas Governor Rick Perry is willing to withdraw $3 billion from the state's rainy day fund to help reduce a $27 billion deficit. Some of his fellow Republicans believe the withdrawal should be much greater.

To an unusual degree, rainy day funds have become a point of contention for state lawmakers this year — even when those lawmakers come from the same party.

In Texas, which has one of the flushest rainy day funds in the country but also faces a shortfall of up to $27 billion over the next two years, Governor Rick Perry was initially reluctant to use money from the reserve to shrink the deficit. He hoped to solve the problem entirely with budget cuts. Perry finally agreed with the House of Representatives to withdraw $3.1 billion from the $9.4 billion fund; the state Senate wants to withdraw twice that much. Both sides in the debate are Republican, but there are few signs that an agreement is at hand. "It has never been the highly charged political issue that it is today," says Dale Craymer, head of the Texas Taxpayers and Research Association in Austin.

In Alaska, GOP lawmakers and Republican Governor Sean Parnell are locked in their own standoff over a problem other states would love to have: what to do with billions of extra dollars the state has collected due to surging oil prices. Parnell wants to enact major tax cuts and sock more money away in Alaska's already-huge reserves, while some lawmakers from his own party want to work on the state's infrastructure and pursue other projects that require more spending.

Meanwhile, in the many states that have emptied or nearly emptied their reserve funds — or never placed much money in them to begin with — serious discussion is taking place over how and when to begin saving for the rainy days of the future.

Here's a primer on how rainy day funds work and on the arguments about how to handle them.

What is a rainy day fund? Sometimes called "budget stabilization funds," rainy day funds are similar to personal savings accounts that individuals build up to protect against an unforeseen development such as the loss of a job or a big health care bill. However, they are governed by many rules and regulations that make it harder to withdraw money than is true for a simple personal savings account. Rainy day funds have become popular with lawmakers of both parties in recent decades as a way to insulate against sudden revenue drops caused by economic downturns, natural disasters or other emergencies that can hit state budgets hard.

Do all states have them? Kansas and Montana do not have rainy day funds, but every other state does. At least eight states — Alabama, Alaska, California, Iowa, New York, Oregon, South Carolina and South Dakota — have multiple rainy day funds, drawn from different sources and used for different purposes. Arkansas and Washington are among the states that have created rainy day funds in recent years.

How do they work? Rainy day funds are built up over time from a variety of sources, depending on the state. These include dedicated revenue streams, such as oil and natural gas severance taxes in Texas, tobacco settlement funds in New Mexico or lottery proceeds in Oregon; year-end budget surpluses that occur when revenues exceed expenditures; and general fund appropriations that legislators choose to make.

Most states set aside money on the assumption that it will be used only during genuine emergencies, for example, a sudden loss of tax revenue or a sudden increase in demand for an entitlement program, such as Medicaid. Indeed, more than a dozen states require a supermajority vote in the legislature to access these funds, making them hard to use for ongoing expenses and other non-emergency purposes. At least 37 states also cap the amount of money that can be accumulated, according to the National Conference of State Legislatures.

How well-stocked are states' rainy day funds today? Without question, it has been "raining" in many states for several years already. Dozens of states have tapped some or all of their rainy day funds as they have patched together budgets during an extraordinarily long period of economic stagnation and dwindling tax collections.

According to the National Association of State Budget Officers, 17 states had completely drained their reserve funds as of last fall, the last time the association published its semiannual national overview . At least 13 states have used rainy day funds to help balance their current budgets and 23 did so last fiscal year, NASBO reports.

Ohio is an extreme example. In 2009, the state had a rainy day fund of more than $1 billion. Today, the fund has a balance of 89 cents. Former Governor Ted Strickland emptied the reserves in 2010 to balance the budget during his final year in office.

Which states have the biggest reserves? Alaska has the nation's biggest rainy day fund by far, both as a percentage of the state's expenditures and in the overall dollar amount. With more than $11 billion in the bank, the state has nearly 200 percent of its budget available for emergencies — and the recent surge in oil prices has produced a fresh windfall for Alaska's petroleum-dependent revenue system. The reserves are so large that Parnell, the governor, recently asked reporters, "Really, how much (money) is enough?"

Four other mineral-rich states — North Dakota, Texas, West Virginia and Wyoming — round out the top five states in rainy day funding as a percentage of the overall budget, though Texas, because of its size, is far ahead of the others in overall dollars. Together, Alaska and Texas account for almost 70 percent of the nation's rainy day fund dollars.

How big should a state's rainy day fund be? While there is broad bipartisan agreement that rainy day funds are a good idea, there is far less agreement on the proper size of the fund,  particularly because the money could be returned to voters in the form of tax cuts if it were not placed in reserve. That is what is driving the GOP budget debates in Alaska and Texas.

For years, conventional wisdom has held that 5 percent of a state's budget should be kept in cash reserves, but that number has been criticized in recent years as arbitrary. Many fiscal experts now believe that the size of a rainy day fund should depend on the state's revenue structure, and that a one-size-fits-all approach is not appropriate. Some states, for instance, either have no income tax or no sales tax (New Hampshire lacks both), meaning that their revenue systems are less diversified and could be susceptible to greater fluctuations. These states may need a bigger reserve fund than others.

"I have not been able to find anything that backs up (the 5 percent recommendation)," Scott Pattison, NASBO's executive director, says. "Why would you pick 5 percent versus 7 percent versus 3 percent?"

State budget directors tend to want as much money as possible in rainy day funds, as do organizations that advocate against deep state spending cuts that upend government programs. One such group, the Center on Budget and Policy Priorities in Washington, D.C., has recommended that states keep rainy day funds amounting to at least 15 percent of their budgets.

Conservatives see things in a different way — but not in a uniform way. Most Republicans believe it is sound money-management policy to have a savings account in place, especially because having one can help prevent future tax increases and can win better credit ratings from Wall Street, making borrowing cheaper. But many GOP lawmakers and activists also believe that government should return some or all of its extra revenue to the taxpayers who provided it in the first place. That has been the position of Parnell, Alaska's governor, who wants to cut taxes on the oil companies that have made his state's rainy day fund the envy of the rest of the nation.